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A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

– The interest portion of your mortgage payment and your property taxes are tax deductible
– If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
– If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
– If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
– If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
– If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
– If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.

You probably couldn’t stop your accountants from allocating overhead to your operating profit centers, even if you tried. I’m not a business historian, but somewhere along the line, accountants everywhere became convinced that allocating overhead to operating unit P&Ls results in a better understanding of profitability. That may or may not be true, but let’s not use an accounting concept for making business decisions.

What is Overhead?

Overhead has a different meaning in every company, and its calculation varies widely. Generally speaking, though, it is considered to be the cost of running a head office, including centralized costs such as executive salaries, office rent, computer systems, etc. When the accountants allocate overhead, it is often in the form of a percentage of gross revenue. If a company has a division that contributes 10% profit, and another that contributes 8%, a 4% overhead allocation would reduce these results to 6% and 4%.

In this example, it would appear that the first division is 50% more profitable than the second, and management might be tempted to allocate resources accordingly. But its contribution margin is only 25% higher, so the result could be misleading.

If you can’t tell if your operations generate enough profit to cover overhead, you might consider looking for a different occupation. For the record, I’m sure many intelligent people disagree with me.

Don’t include Overhead in your business decisions

In my experience, many accountants don’t really appreciate that accounting conventions have no place in business decision-making, and operating executives often don’t feel confident enough to challenge the accountants on their own turf. Some things to remember:

Overhead is just an accounting concept
Overhead does not affect cash flow
Overhead allocations do not affect total company profitability
Overhead is calculated differently in every company

I have seen some dysfunctional results arise from trying to shoe-horn an accounting concept into business decisions.

A Retailer

A retailer had several stores that were not only losing money, but had a negative cash flow. That is, their operating loss was greater than their depreciation and amortization. The stores clearly needed to be closed to stop the damage.

The CEO, however, had done his math. If he closed the failing stores, the overhead allocated to those stores would have to be redistributed to the remaining stores, reducing their accounting profit after overhead. The CEO could not be persuaded that closing the losing stores would improve the company’s total profitability.

The failing stores continued to lose cash flow, and the overhead was allocated to all stores… until the CEO was replaced.

A Homebuilder

A homebuilder had a target IRR for new community construction projects. IRR is a measure of cash flow that calculates the return realized on a cash investment. The CFO, an accountant by training, insisted that all cash flow projections include a 3% charge for overhead, despite the fact that overhead has nothing to do with the incremental cash flow generated by a new construction project. He argued that when the project was under way, overhead would be allocated for accounting purposes, so the pro formas should reflect that. The pro formas then became just a forecast of the accounting records, and IRR, the real reason for making the investment, was calculated incorrectly.

At least the pro formas were conservative as a result of this allocation, but the company probably missed out on some good opportunities whose IRR projections fell below the hurdle rate. As it happened, the company’s actual overhead was not even 3% at all.

Another Retailer

Some retailers charge the cost of their distribution centers directly to expense, in the manner of unallocated overhead, while others include it in the cost of their merchandise, charging it directly to operations.

In a year when earnings were tight, I was encouraged as division CFO to find ways to increase reported profit, so I capitalized the distribution center costs. This resulted in a large transfer of costs from expense to inventory, substantially increasing reported earnings. The parent company paid senior management large bonuses that year, regardless of the fact that nearly all our profit came from an accounting change.

Although we reported more profit, the actual economic impact on the company was a negative cash flow in the amount of the bonuses that were paid. Was the accounting technically correct? Yes. Was it the most appropriate accounting under the circumstances? Maybe not. Would I do it again? … Well, I did like that bonus.

A Land Developer

When a land developer sold finished and partially finished lots to homebuilders, they did a land residual calculation to arrive at the asking price. That is, they estimated all the builder’s costs and revenues, and priced the lots so the builder could achieve a specified percentage profit margin. But one of the costs included in the analysis was 3% – again 3% – for overhead. If they didn’t include the overhead, they could have started with a higher asking price, and maybe sold the lots for a higher price.

Both the CEO and the CFO of a large company told me that ROI and IRR are the same thing. They’re not. Interestingly, both executives’ annual bonus was determined by how their ROI compared with other companies in the industry.

I worked for a big company that required a 16% after-tax IRR on new investments. As it happened, the company’s ROI was typically in the 16% range. The Director of Financial Planning told the operating teams that achieving a 16% IRR automatically resulted in a 16% ROI… But he was wrong. It was just a coincidence.

Another company required an 18% pre-tax IRR on new investments, and for several years reported an ROI of about 18%. That was also a coincidence.

ROI and IRR are very different calculations, and are used for very different purposes.

Return on Investment (ROI)

ROI is a measure of how effectively a company is utilizing its capital investment. It measures the company’s profit during a fixed period of time, usually one year, divided by its average assets.

Taxes and interest are excluded from the calculation in order to compare the performance of different companies more effectively. A company with a low tax rate, or a highly leveraged company will have very different result from those of a company that has higher taxes or operates with low debt levels, so this calculation removes those variables. Other calculations, such as Return on Equity (ROE) evaluate performance on a more comprehensive basis.

Non-interest bearing liabilities include items like accounts payable and accrued liabilities, which are effectively free financing, so the corresponding assets aren’t really considered to be an investment.

How Useful is ROI?

ROI is a widely used calculation, but we must remember that it measures only one year’s performance, so it can swing widely from year to year if earnings are volatile. This may not be a bad thing in cyclical businesses, in which all companies experience the same environment.

In my opinion, ROI is most useful in established companies that are not growing or contracting at a rapid rate. The book value of a young company or a growing company’s assets is likely to be relatively high, as they invest in future earnings, and haven’t charged off extensive depreciation and amortization.

Conversely, there is an old joke that the best way to increase your ROI is to go out of business, because your investment is declining as you sell off assets, while you still report income from the sale of those assets.

Similar Calculations

There are plenty of slightly different calculations such as Return on Net Assets (RONA), Return on Capital (ROC) and Return on Invested Capital (ROIC) that can be argued to be more representative of a particular company’s performance, but they all have the same basic objective.

Internal Rate of Return (IRR)

IRR calculates the compound rate of interest earned over the life of a specific investment, using not only the dollar amounts, but also the timing of cash expenditures and cash receipts. Because it uses the concept of the “time value of money,” IRR is used to compare investment opportunities that have very different cash flows.

Calculating IRR

IRR is based on the concept of Net Present Value (NPV). NPV says that one dollar today is worth exactly one dollar. A promise to receive one dollar a year from now, however, is worth less than a dollar, because you’ve missed the opportunity to earn income on that dollar for a year. If you could earn 10% (the Discount Rate) on your investment, next year’s dollar would be worth only 90.9 cents today ($1.00 divided by 110%). On the bright side, a future expense is also worth less today.

IRR is the Discount Rate at which the NPV of a series of cash flows is zero. That is, the interest rate earned over the life of an investment after the initial investment has been repaid.

Typically, interest and taxes are also excluded from the IRR calculation for comparison purposes, but of course, you will want to see the net leveraged IRR too.

How Useful is IRR?

If you have $1 million cash to invest, should you invest in the project that requires the entire investment up front, then pays nothing for 3 years, when it returns $1.5 million? Or should you go for the one that requires a $500,000 investment in each of the first two years, and then pays $350,000 a year for the next 5 years? There are obviously a lot of other factors to consider, but IRR will tell you which one pays a higher return.

How do you decide which projects to invest in? Some companies look at the expected profit as a percentage of expected revenue. This approach, however, does not take into account the size of the investment, how long your money is tied up, or the risk of the investment.

Many companies look at their expected Internal Rate of Return, or IRR. This is a measure of the cash flow of the investment over its expected life, and gives the annual percentage return on the actual cash invested. Some companies informally call this their Return on Investment, although ROI is technically a different measure.

Companies in different industries have their own criteria for a minimum acceptable IRR. Retailers, for example, often look for a 16% return after tax, while homebuilders might look for 18% before tax. The differences are based on the risk involved in the investment. Profit projections are less reliable for a new retail store than for building houses in an established development – under normal circumstances, of course. Retailers also expect their investment to last at least 10 years, while a housing development can often be completed in 2 or 3 years. A lot of things can change in 10 years.